Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
SPLIT STRIKE CONVERSION
I am interested in information on implementing a split strike conversion strategy to hedge/stabilize an existing portfolio. I understand the basic strategy of buying at-the-money puts and writing out-of-the-money calls, but which contracts should I be concentrating on? One month, three months, six months out? Any help would be appreciated -- Sunseeker
The strategy you describe is known as a collar: It's a combination of a protective put and a covered call. The strategist is placing a floor on the potential losses of a stock by purchasing a put. The sale of the call helps offset the cost. However, the sale of the call will also limit the potential gains, because if the price of the underlying stock moves higher, the call may be assigned. The chance of assignment will increase as the stock moves higher above the strike price of the option and the expiration date approaches.
So the collar is a limited-risk, limited-reward strategy. Some traders consider it a type of "vacation trade," because you can establish the position and not worry about what happens until options expiration approaches. As you point out, the collar can also be used to stabilize or hedge a portfolio. In that case, the choice of expiration month will depend on how long you want protection. You can even use long-term equity anticipation securities (LEAPS) if you want to hold the position for several months or years. So the time frame is up to you, but if you choose shorter-term rather than longer-term options, you may pay more in commissions over time.
CLOSING A STRADDLE
Would you please explain how to close a straddle -- that is, how should I tell my broker I am closing the following trade? I bought two XYZ May 50 calls and two XYZ May 50 puts, for a debit of three opening both sides. -- kola
An options trade is either an opening or closing transaction. An opening transaction is the strategist's entry into a position. For instance, if you want to buy the two XYZ May 50 calls to establish the first side of your straddle, you would instruct your broker to buy two XYZ May 50 calls to open. This is referred to as legging into a trade -- that is, you are planting the first leg of your straddle when you buy the calls. After buying the two XYZ May 50 calls, you instruct your broker to buy two XYZ May 50 puts to open. The put purchase is the second leg of your trade.
To exit the position, you would want to sell the two XYZ May 50 calls to close and sell the two May 50 puts to close. Of course, you could sell the calls after selling the puts. It doesn't really matter which side of the leg is planted first.
Many brokers will allow you to place the straddle as one order. This is what I prefer, because the market can move against you when you are legging into a trade. So in your example, you would instruct the broker to buy two XYZ May 50 straddles to open. When you want to exit the trade, you would sell two XYZ May 50 straddles to close. You can also specify a limit price when sending the trade with your broker. An experienced options broker will be able to work with you and help you get the best fills on your straddle order. Don't be afraid to contact your broker for more information regarding the specific order-entry protocol.
TRADING THE DOW JONES INDUSTRIAL AVERAGE
What does DJIA stand for? -- Rookie Trader
DJIA is the acronym for the Dow Jones Industrial Average. Charles Dow created the average in 1896, and it remains one of the most widely watched market averages today. At the time of its inception, the index represented 12 of the US leading industrial companies. Today, it includes 30 stocks, including 28 NYSE-traded stocks and two Nasdaq-listed stocks, Microsoft (MSFT) and Intel (INTC). Only General Electric (GE) remains as one of the original members of the average. Most quote services today use the symbol $Indu, not DJIA, to find the latest value of the index.
For options traders, there are two ways to trade the DJIA. First, options on the Dow Jones Industrial Index ($Djx) trade on the Chicago Board Options Exchange (CBOE). This index equals 1/100th of the industrial average. So if the DJIA approaches 10,000, the DJX will be near 100. These options settle for cash. On the other hand, the Dow Jones Diamonds Trust Series (DIA) is an exchange-traded fund that holds the same 30 stocks as the Dow Jones Industrial Average. It is also equal to roughly 1/100th the size of the industrial average. However, since the DIA is a fund, it can be bought and sold like a stock and the options settle for shares, not cash.
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Originally published in the September 2004 issue of Technical Analysis
of STOCKS & COMMODITIES magazine.
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